Do US Markets Really Need a “Supercop”?

On Monday, March 31, Secretary of Treasury Henry Paulson announced a “blueprint” for financial regulation reform. Calling his system the “supercop,” Paulson’s vision calls for a more nationalized and hierarchical regulation commission with increased sway over the private sector. Many are applauding Paulson’s approach as a critical element to help the United States exit the current recession and avoid the growing menace of stagflation. Without question, capital markets are highly constricted at the end of Q1 2008, but when we survey a brief history of US financial control measures, we find that Paulson’s “big muscle” strategy may not be the best answer to the current crises.

America’s current financial regulatory agencies started coming under a great deal of criticism with market developments in mid-2007 and negativity has been expanding ever since. Tentative worry that began in summer 2007 when the rough underbelly of the subprime mortgage industry became publicly apparent has, with the March dissolution of the esteemed investment bank Bear Stearns, mounted to a deafening level. As the United States struggles through a recession and as the job market continues to contract, Main Street is demanding answers from Wall Street. At the bottom line, the proliferation of derivative contracts means that bankers often don’t understand exactly what securities they actually own in the modern marketplace. Moreover, by using complex instruments, financiers are now able to take on exorbitant amounts of risk by “hiding” leverage and exposure within the convoluted terms of an agreement.

One obvious result of these measures is that many bankers have grown wary to engage in lending and borrowing, causing the economy to stagnate. To counter this trend, the Federal Reserve has dropped the Fed Funds rate (the rate at which banks/depository institutions lend money to other banks/depository institutions, usually overnight) five times from its long plateau at 5.25% in 2007 down to a late-March 2008 target rate of 2.25%. This trend, coupled with the government’s “bail out” measures to allay chaos during the Bear Stearns debacle, echoes the Long-Term Capital Management calamity of 1998. During that event, the Federal Reserve Bank of New York under the guidance of William McDonough organized a $3.625 billion bail out of the LTCM hedge fund after the fund’s portfolio was rocked by the collapse of Russian and East Asian bond markets during late-1990s lulls associated with currency devaluations.

Long Term’s brain trust, including numerous Nobel Prize winners and elite professors, had developed a subtle method of achieving returns through risk arbitrage—by avoiding correlation in their positions, LTCM’s traders could take on massive amounts of leverage with disproportionately small risk. For years this strategy was, according to the Lebanese economist Nassib Taleb, “like picking up pennies in front of a steamroller” yielding good odds that LTCM would make small gains against small odds that they would take on huge losses. Outside events of 1998 changed the arithmetic of this equation, making the placement of orders more like a game of Russian roulette. Rapidly, LTCM’s portfolio took on a negative expected value, and not long thereafter this math came to fruition. Without warning, it appeared the system of global capital markets was folding in on itself, needing immense regulation and bigger watchdogs if it was to survive.

To say that LTCM marked the first occasion of near doom is inaccurate, however. Paulson’s March 31st announcement in many ways comprises yet another link in a long chain of US government attempts to tame capitalism, even as relatively untamed markets are arguably the dynamo of American prosperity. The Federal Reserve system was initiated in 1913 in response to the Panic of 1907—responsibilities for oversight were divided between 12 regional banks who in turn were tasked to closely monitor financial activity locally. The Great Depression saw beefier reforms on the government front mounting with the Glass-Steagall Act of 1933 that separated commercial and investment banking and required Federal Reserve notes to be collateralized with US Treasury securities. 1934 and 1935 built on this measure when respectively the SEC was formed as a “fair practices” enforcement organization and the Banking Act further shifted regulatory power from a local to a federal level through the creation of the Federal Open Market Committee.

When things get bad in the markets, it seems, the government conceives its role as a bigger one. More recently, we can see this in the bubble economy enactment of the Gramm-Leach-Bliley Act (1999) effectively negating Glass-Steagall stacked so chronologically close to the post-bubble Sarbanes-Oxley Act (2002) that mandated for more stringent corporate oversight and financial disclosure (in large part this particular measure was prompted by the Enron debacle).

In this historical light, Paulson’s “supercop” referendum may indeed look appropriate given present uncertainties. Subprime mortgages packaged into CDO (“collateralized debt obligation”) securities with exaggerated credit ratings may indeed represent the next “Great Crash,” the next LTCM or the next Enron. But turning back to history, we must also heed another firm fact—free market incentives exist regardless of the regulatory atmosphere and the cream of the crop on Wall Street always seem to find a way around public sector blockades. Thus Paulson’s motion to consolidate all existing monitoring agencies into a bulky “mega agency” may do more harm than good. The players on Wall Street are paid much better to find ways around legal traps than their Washington counterparts are paid to build those traps, and perhaps then the best method for sniffing out foul cheese is to make the system more horizontal—not hierarchical—so that localized regulators can always have a nose close to the ground.

Another point that Sec. Paulson seems not to have considered fully is that market imperfections spur market dynamism as economic actors naturally seek to reestablish equilibrium. For capitalism to function, this kind of “plate-spinning” scenario must be allowed and fostered. Right now, Americans rightly fear for the financial system, but the answer to that fear is better found in The Wealth of Nations than it is in Hank Paulson’s “Robocop” vision—the market, in the end, will always sort itself out when agents implement their personal incentives and when a bare level of regulation exists to enforce property rights, contractual obligations and derived concepts.

In the case of the mortgage crisis, banks bought securities that were rated inappropriately high by ratings agencies and they correspondingly took hits when those securities became worth no more than printed paper after expected foreclosures. Correspondingly, these banks now have incentives to certify precisely the terms of their own securities in future transactions. While the immediate effect of the crisis is that banks are scared to engage in significant capital market activities, the forces of the competitive market and the balance sheet will soon compel them to reenter the arena full-force. If a supercop is present in that arena, it does little but delay and hinder the inevitably vital plate-spinning that must resume regardless of whether or not it occurs in an environment of massive bureaucratic scrutiny.

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